We’ve written extensively about the UBS Puerto Rican
Municipal Bond Funds. You can find our earlier blog posts here.
Puerto Rico’s unique tax regime keeps coming up and we thought it was worth a
blog post clearing this matter up.

Puerto Rican residents don’t pay federal income tax but do
pay very high income taxes. The Puerto Rican maximum marginal income tax rate
is 33%, reached at only $50,000 per year of taxable income.

The income on Puerto Rican municipal bonds is exempt from
the state income tax that would be paid by Puerto Rican investors who bought
municipal bonds issued in other states.This difference in tax treatment is one of the justifications offered
for the alarming concentration of UBS clients in UBS proprietary closed end
funds stuffed with Employee Retirement System bonds underwritten by UBS.

This tax justification for concentrating Puerto Rican
investors in Puerto Rican municipal bonds is economically identical to arguing
that investors ought to concentrate their portfolio in the single stock with
the highest expected return. For example, it is equivalent to arguing that
investors should put 100% of their investments (or to take the UBS approach,
substantially more than 100% of their investments) in Zoom.inc because it has
the highest beta and therefore the highest expected return. You don’t have to
be old enough to remember the tech wreck to know this is unsound advice because
it ignores the very high risk associated with a concentrated and leveraged
investment in Zoom.inc.

We plot the annualized return and risk from 2003 to 2012
derived from Standard and Poor’s Municipal Bond Indexes in Figure 1. The red
dots represent combinations of risk and return for state specific indexes, the
blue dots represent national portfolios and the green dot is Puerto Rico.
Notice that Puerto Rican municipal bonds had lower returns and higher risk than
the mainland states and national municipal portfolios before the losses in 2013.

Figure
1. Average Annual Pre-Tax Total Returns and Standard Deviations for Puerto
Rico, 26 States and 9 National Municipal Portfolios.

The slope of a line from the origin to a point on the graph
is the ratio of realized returns to realized risk. This is sometimes referred
to as a Sharpe Ratio. Portfolios with higher returns per unit of risk (i.e. steeper
slopes) are preferred.

Ignoring taxes, Puerto Rican municipal bonds experienced
lower risk-adjusted than the 26 individual states with 10 years of data.
Contrary to parties defending the concentration in Puerto Rican investors’
accounts, that judgment still holds when we incorporate taxes.

We plot the returns and risk from Figure 1 after reducing the
returns by the maximum marginal income tax rate in Figure 2. The cloud of red
and purple dots have become triangles and shifted in toward the origin but
remain above the dotted line connecting the origin with Puerto Rico’s realized
risk and return.

Figure
2. Average Annual After-Tax Total Returns and Standard Deviations for Puerto
Rico, 26 States and 9 National Municipal Portfolios.

We could complicate this analysis further by separating out
coupon interest from capital gains and losses but the result remains unchanged.
The tax benefit Puerto Rican investors receive increases the after tax returns
and risk of investing in Puerto Rican municipal bonds relative to investing in
the municipal bonds issued in other states – and the Puerto Rican municipal
bonds were already much more risky than bonds from other states.

Differences in estate taxes also don’t explain the
concentration observed in Puerto Rican investors’ accounts. Exemptions from estate taxes available to Puerto Rican investors apply to other assets – not just municipal bonds and funds that hold them – and so don’t justify such concentrations in the UBS Funds and UBS underwritten bonds.

Exemptions from estate taxes available to Puerto Rican investors apply to other assets – not just municipal bonds and funds that hold them – and so don’t justify such concentrations in the UBS Funds and UBS underwritten bonds.

Other estate planning techniques allow diversified portfolios to pass from one generation to the next in Puerto Rico.

Portfolios were concentrated in UBS Funds and UBS underwritten bonds without regard to whether the estates are small or large.

Portfolios were concentrated in UBS Funds and UBS underwritten bonds without regard to the age of the accountholder.

To sum up, taxes are painful but they don’t justify
concentrating Puerto Rican investors’ portfolios in the UBS Funds or the Puerto
Rican municipal bonds more generally any more than high betas justified
concentrating portfolios in tech stocks.

Friday, October 17, 2014

SEC Obtains Summary Judgment Against Defendants in Securities Fraud Involving Biopharmaceutical Company
October 15, 2014 (Litigation Release No. 23114 )
On October 10, the US District Court for the Northern District of Illinois granted the Commission’s motion for “summary judgment and for partial summary judgment, respectively, against Defendants Douglas McClain, Sr. ("McClain Sr."), of Fair Oaks, Texas, and Douglas McClain Jr. ("McClain Jr."), formerly of Savannah, Georgia. The Court found that McClain Sr. violated the antifraud provisions of the federal securities laws by making misrepresentations and omissions and that McClain Sr. and McClain Jr. engaged in insider trading.” The SEC’s action was filed against the defendants in August 2011. The allegations argue that the defendants were engaged in securities fraud, including misleading investors in public SEC filings and in oral presentations. The defendants had presented a scenario in which regulatory approval for their products was underway, when in fact the FDA had issued clinical holds on their drug applications twice, prohibiting clinical trials from happening altogether. The Court is still in the process of determining appropriate remedies against the defendants.

Jury Finds Anthony M. Knight, Former Chairman of a Failed Internet Startup, Liable for Securities Fraud and Illegal Sale of Unregistered Securities
October 15, 2014 (Litigation Release No. 23112 )
On October 14, a federal court reached a verdict in favor of the SEC, finding that Anthony M. Knight, the co-founder and former Chairman of iShopNoMarkup.com, was liable for “securities fraud and illegally selling unregistered securities.” Knight and his associates defrauded more than 350 investors of about $2.3 million in investments. While US District Judge Denis R. Hurley is still determining remedies, the SEC is “seeking a judgment requiring the defendant to pay disgorgement of ill-gotten gains plus prejudgment interest, as well as civil monetary penalties, an injunction, and an officer and director bar.”

Judgment Against Former CEO Orders Payment of Over $450,000 in Case Involving Scheme to Manipulate Company's Stock
October 10, 2014 (Litigation Release No. 23110 )
The SEC announced that the US District Court for the Southern District of New York had entered a Final Judgment against Thomas J. Kelly on October 9. Kelly, the former CEO of 8000, Inc., was charged with being a party to “a scheme to manipulate the trading volume and price of 8000 Inc.'s common stock by disseminating false information about the company and simultaneously selling, or facilitating the sale of its securities which were not for sale to the general public.” Also charged were Jonathan E. Bryant, an undisclosed principal in 8000 Inc. and the attorney for 8000 Inc, Carl N. Duncan. When 8000 Inc.’s stock price increased due to aforementioned false information, Bryant “sold 56.8 million "restricted" shares of 8000, Inc. into the market with the assistance of Duncan who provided false legal opinions removing the restrictions, and Kelly to have bought and sold the company's securities in the secondary market.” According to the SEC, the volume of trading in 8000, Inc. by 93% and the stock price rose from below $.01 per share to $.42 per share between November 2009 and October 2010. Kelly was ordered to pay $415,592 in disgorgement fees as well as $46,697 in pre-judgment interest. Kelly is permanently barred from “acting as an officer or director of any issuer that has a class of securities registered pursuant to Section 12 of the Exchange Act, and permanently bars him from participating in an offering of a penny stock.”

SEC Obtains Summary Judgment Win On Liability in Ponzi Scheme Case
October 10, 2014 (Litigation Release No. 23111 )
An SEC motion for summary judgment was granted by the US District Judge for the District of Nevada granted on October 3 against Edwin Fujinaga and MRI International, Inc. on all charges levied by the SEC, including antifraud violations. The case, filed on September 11, 2013, alleges that Fujinaga and MRI International, Inc. had been engaged in “an elaborate Ponzi scheme”. According to the allegations, Fujinaga and MRI raised funds in excess of “$800 million from thousands of investors living primarily in Japan under the ruse that MRI was using their investments to buy medical accounts receivable from medical providers at a discount to recover their full value from insurance companies.” The SEC’s allegations go on to say that the defendants had used the investments to pay back earlier investors and further, Fujinaga had used investor funds for personal purchases. The Court found that “Fujinaga had sole control over investment funds, using them for his own personal benefit" and wrote that "[w]hile depleting the pool of collected investments, Fujinaga facilitated a Ponzi scheme funded by new investments." Litigation to determine appropriate remedies will continue.

Friday, October 10, 2014

SEC Obtains Final Judgment Against Paul T. Mannion, Jr., Andrew S. Reckles, Pef Advisors LLC, and Pef Advisors Ltd.
October 8, 2014 (Litigation Release No. 23108 )
The SEC announced that on September 29, 2014, the US District Court for the Northern District of Georgia entered a final judgment against Paul T. Mannion, JR., Andrew S. Reckles, PEF Advisors LLC and PEF Advisors Ltd. The Court found that Mannion and Reckles, co-owners of both PEF Advisors entities, had violated Section 206(2) of the Investment Advisers Act by “personally exercising stock warrants that belonged to the Palisades Master Fund, L.P. (Fund), a hedge fund client defendants advised.” Mannion and Reckles have each been ordered to pay a $75,000 penalty, have been permanently barred from association with any “broker, dealer, investment adviser, municipal securities dealer, or transfer agent, prohibited each of them from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter” and are barred from participating in the promotion or sales of penny stocks.

Massachusetts-based Penny Stock Promoter Ordered to Pay Over $700,000 in SEC Fraud Case
October 8, 2014 (Litigation Release No. 23107 )
The Commission announced that the US District Court for the District of Massachusetts had entered a final judgment against Geoffrey J. Eiten on October 7. An action was initially filed by the SEC in December 2011, charging that Eiten and his company, National Financial Communications Inc, had “made material misrepresentations and omissions in penny stock publications they issued.” The final judgment orders Eiten to pay $727,029 ($605,262 in disgorgement, $71,767 prejudgment interest and $50,000 in civil penalties). Eiten is also barred from promoting or engaging in the sales of penny stocks.

SEC Shuts Down $123 Million Atm Ponzi Scheme in California
October 8, 2014 (Litigation Release No. 23106 )
Charges were announced today against Nationwide Automated Systems, the company’s owner Joel Barry Gillis and Edward Wishner, a senior officer. The case was unsealed on October 7 by the federal court in Los Angeles. The SEC has obtained an emergency court order, freezing the defendant’s assets. In what the Commission alleges was a classic Ponzi scheme, funds in excess of $123 million were raised by NAS. Gillis and Wishner told investors that “they could purchase ATMs from NAS and then lease them back in return for “rent” of 50 cents per ATM transaction. Investors were guaranteed an investment return of at least 20 percent per year in these sale-and-leaseback agreements. However, the vast majority of NAS’s revenue is from new investor funds, and this money is being used to pay the promised returns owed to earlier investors. NAS does not actually own most of the ATMs it claims to operate, a fact unknown to investors who were contractually forbidden in their agreements from contacting the locations where their ATMs were supposedly located.” In fact, the SEC noted that, while NAS had claimed to operate somewhere in the range of 31,000 ATMs, it actually only owned about 235 ATMs.

Court Imposes Injunctions and Monetary Sanctions of Over $350 Million Against Nikolai Battoo and His Companies
October 6, 2014 (Litigation Release No. 23104 )
The SEC announced that on September 30, the US District Court for the Northern District of Illinois had issued an Order and Final Judgment against Nikolai Battoo, BC Capital Group S.A., and BC Capital Group Limited. The latter two defendants were companies under the control of Mr. Battoo. Battoo and his companies were ordered to pay $290,129,196.86 in disgorgement and prejudgment interest. In addition, Battoo and his companies were ordered to pay a $68 million civil penalty. Judge Edmond E. Chang, who presided over the case, wrote that the high penalty was justified due to “the sheer enormity of the fraud, both in dollar figure and number of investors. There must be a substantial penalty both to punish the Battoo Defendants, and to deter others from committing fraud on this scale.” According to the SEC, Battoo managed hedge funds that defrauded investors “by claiming to achieve exceptional risk-adjusted returns while concealing huge losses suffered by his asset management operation and his misappropriation of investor funds to pay for his flamboyant lifestyle.” After funneling about $49 million from investors into his own accounts, Battoo, starting in 2008, distributed false account statements to investors to cover up the theft.

SEC Files Subpoena Enforcement Action Against John Puglisi, Progressive Capital Solutions LLC, and Others
October 6, 2014 (Litigation Release No. 23105 )
The SEC announced that it had filed a subpoena enforcement action in the US District Court for the Eastern District of Pennsylvania against defendants John Puglisi and Progressive Capital Solutions LLC. The litigation, brought by CMS Life Insurance Opportunity Fund LP and CNF II Partners alleges that Puglisi and Progressive Capital Solutions “had been stealing the investments and selling them for their own benefit”. The subpoena enforcement action was required because the defendants had not complied with previously issued administrative subpoenas.

Friday, October 3, 2014

SEC v. Patrick G. Rooney, John R. Rooney, and Positron Corporation, Civil Action No. 9:14-cv-81224-KAM (U.S. District Court for the Southern District of Florida)
October 3, 2014 (Litigation Release No. 23103)
The SEC announced that on September 30, it had filed a civil injunctive action against Positron Corporation, Patrick Rooney, the company’s former CEO and John R. Rooney, a promoter of penny stocks. Positron, a microcap company, as well as Patrick Rooney and John Rooney have been charged with a scheme to manipulate the market in relation to Positron stock. The Commission alleges that “Positron Corporation, Patrick Rooney, and John Rooney, engaged in market manipulation fraud in which they made an inducement payment to a stock promoter who would purchase shares of Positron in the open market ahead of planned press releases to help them manipulate the stock. The SEC alleges that the scheme was designed to generate the appearance of market activity in the company's stock to induce investors to purchase the stock and artificially increase the trading price and volume.”

Former Cleveland-Area Investment Promoter Oscar F. Villarreal Indicted
October 1, 2014 (Litigation Release No. 23102)
Following an SEC Complaint filed on August 26, the US Attorney for the Northern District of Ohio, on September 16, secured a grand jury indictment against Oscar F. Villarreal. Villarreal was charged with “ten counts of wire fraud, seven counts of money laundering, one count of securities fraud, and one count of investment adviser fraud.” According to the SEC, from March 2009 to December 2010, Villarreal masterminded and directed a fraudulent offering, raising $9.2 million from 46 investors. “Villarreal told investors that their money was to be used to make private equity investments in companies in the petroleum, steel, and other industries in Mexico. Villarreal lied to these investors about the success of a previous fund he operated, lied in saying that he used their money to purchase and profitably operate a Mexican pipeline manufacturer, and lied by telling investors that Fund III had ownership interests in several U.S. and Mexican drilling companies. Villarreal instead used $7.4 million of Fund III assets to trade in publicly traded securities in a brokerage account-contrary to his representations to investors-and sustained heavy losses, and also stole $5.8 million for himself. By November 2011, Fund III was essentially insolvent.” The SEC is seeking a permanent injunction, disgorgement and prejudgment interest, in addition to civil penalties.

The Securities and Exchange Commission ("Commission") Announced That On September 24, 2014, George B. Franz III ("Franz") Was Sentenced for His Obstruction of an SEC Investigation and Making False Statements to SEC Staff
September 30, 2014 (Litigation Release No. 23101)
On September 24, the SEC announced that George B. Franz III had been sentenced for obstruction of an SEC investigation as well as for making false statements to the SEC. Franz’s sentence includes three years of probation and a fine of $25,000. In addition, the Court ordered Franz to make a $250,000 payment to the SEC to compensate the Commission for “diversion of investigative resources caused by Franz’s obstructive conduct.” In June of this year, “Franz pleaded guilty to one count of obstruction of an official proceeding, one count of destruction or falsification of records in a federal investigation, and two counts of providing false statements and documents to an agency of the executive branch.” The criminal acts occurred over the course of the Commission’s investigation of Franz and Ruby Corporation. Last September, this investigation ended in an Administrative Proceeding, with the SEC alleging that Franz and Ruby lied to clients regarding account thefts. Franz and Ruby agreed to a settlement in which they paid a $675,000 in civil penalties and $425,000 in disgorgement.

SEC Charges Pennsylvania-Based Registered Representative with Stealing Funds from Customers
September 30, 2014 (Litigation Release No. 23100)
The SEC charged Dennis F. Wright of stealing his client’s funds for personal use and subsequently forging their account statements. The SEC’s complaint alleges that Wright stole funds in excess of $1.5 million from “at least 28 customers”. The US Attorney’s Office for the Middle District of Pennsylvania also announced criminal charges against Wright. For his part, Wright agreed to settle the Commission’s charges and to disgorge the stolen funds. By order of the SEC, Wright will be permanently barred “from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; and barring him from participating in any offering of a penny stock.” The SEC investigation was conducted in conjunction with the US Attorney’s Office for the Middle District of Pennsylvania as well as the FBI.

Court Imposes Injunctions and Monetary Sanctions of Nearly $30 Million Against Former CEO and CFO of Electronic Game Card
September 30, 2014 (Litigation Release No. 23099)
The SEC announced that, on September 22, the US District Court for the Southern District of New York had “issued an opinion and order imposing financial sanctions of more than $29.6 million on Lee Cole and Linden Boyne, the former CEO and CFO of Electronic Game Card Inc.” The SEC’s complaint, filed in November 2012, outlined the lengths that Boyne and Cole had gone to to defraud investors. In an effort to attract investment, both defendants told investors that the company “had millions of dollars in annual revenue, millions of dollars in investments, and an off-shore bank account worth more than $10 million. In fact, many of EGMI's purported contracts were phony, the purported investments were actually in related-party entities affiliated with Cole or Boyne, and the bank account did not exist.” At one point, the SEC noted that EGMI’s outstanding common stock was valued around $150 million. After filing for bankruptcy, its stock is now entirely worthless. Cole and Boyne channeled millions of EGMI shares to other entities they controlled, subsequently selling those shares and realizing profits in excess of $12.3 million. “Granting a motion for relief made by the Commission, Judge Sullivan's recent order holds Cole and Boyne jointly and severally liable for disgorgement of $12,345,908.74 plus $2,324,842.25 in prejudgment interest and requires each to pay a civil penalty of $7,500,000.00. Judge Sullivan's order also permanently enjoins Cole and Boyne from violating the securities laws, serving as officers or directors of any public company, and participating in any activities involving the offer of penny stocks.”

Court Imposes Injunctions and Monetary Sanctions of Nearly $30 Million Against Former CEO and CFO of Electronic Game Card
September 30, 2014 (Litigation Release No. 23098)
On September 25, the SEC filed a civil injunctive action against Wealth Strategy Partners, LC, its principal, Harvey Altholtz, Stevens Resource Group, LLC and its principal, George Stevens. The defendants have been charged with securities fraud involving fraudulent offers and sales of securities in The Stealth Fund, LLLP and The Adamas Fund, LLLP. The funds were controlled by Wealth Strategy and Altholtz, while Stevens Resource and Stevens served as investment advisers for both funds. Taken together, the two funds raised about $30.8 million from more than 143 investors between 2007 and November 2009. According to the SEC, the defendants did not disclose to investors that their assets might be used to “guarantee certain loans that Altholtz's family made to two portfolio companies that Stealth invested in and that his family also made loans to Adamas and Stealth in violation of the funds' operating agreements. The complaint also alleges that Wealth Strategy and Altholtz committed fraud by giving an Altholtz family trust, who was an investor in Adamas, preferential treatment over other investors with regard to redemptions. The complaint further alleges that the defendants made misstatements and omissions in newsletters to investors regarding the financial condition of some of the funds' portfolio companies.” The SEC is seeking permanent injunctions, disgorgement as well as prejudgment interest and civil penalties against all of the defendants. The SEC is also seeking to impose a permanent officer and director bar against Altholtz. Stevens and Stevens Resource have already settled and agreed to a permanent bar.

Court Imposes Injunctions and Monetary Sanctions of Nearly $30 Million Against Former CEO and CFO of Electronic Game Card
September 30, 2014 (Litigation Release No. 23097)
In May of this year, the SEC “filed an emergency action charging Thomas Abdallah, Kenneth Grant, KGTA Petroleum Ltd. ("KGTA"), Mark George, Jeffrey Gainer and Jerry Cicolani with participating in a fraud involving a sham oil trading business, KGTA, that raised over $20 million from investors.” Allegedly, Grant and Abdallah had persuaded potential investors to invest by making many false claims and promises. In reality, KGTA was a sham business, and was being operated as a Ponzi scheme. An escrow safeguard that Grant and Abdallah had promised investors also proved to be entirely false. The US District Court in the Northern District of Ohio “issued a series of Orders granting injunctive relief, freezing assets and other emergency relief as to all of the defendants and relief defendants.” The SEC’s investigation into KGTA and the defendants is slated to continue.

SEC Charges China Valves Technology, Inc. and Three Senior Officers with Fraud
September 29, 2014 (Litigation Release No. 23096)
The SEC’s Cross-Border Working Group, a division that deals largely with companies that have significant foreign operations but are publicly traded in the United States, is proceeding with its latest case, filing a civil injunctive action against China Valves Technology, Inc. in the US District Court for the District of Columbia. The charge alleges that China Valves and its chief officers Fang, Wang and Tang were involved in intentionally “misleading investors about the true nature and price of an acquisition and by mischaracterizing and materially overstating income related to its purchase and reverse engineering of a competitor's product.” The SEC’s investigation will continue.

Securities and Exchange Commission v. Michael B. Ferguson and Transactions Unlimited, Civil Action No. 3:14-cv-04188 (N.D. Cal.)
September 29, 2014 (Litigation Release No. 23095)
The SEC charged Michael B. Ferguson and his company, Transactions Unlimited (formerly DBA ATM Plus), with cheating investors out of more than $12 million in a fraudulent ATM scheme. Beginning in 2005, Ferguson’s scheme was “the hallmark of a Ponzi scheme” according to the Commission. Ferguson was arrested in March of this year and charged with securities fraud, burglary and grand theft by the Santa Clara County District Attorney’s Office. The SEC is seeking “permanent injunctions, return of allegedly ill-gotten gains, and civil penalties.”

Securities and Exchange Commission v. Erick Laszlo Mathe and Ashif Jiwa, Civil Action No. 14-CV-23573-GAYLES/TURNOFF (S.D. FL.)
September 29, 2014 (Litigation Release No. 23094)
The SEC charged Erick Laszlo Mathe, the former CEO of Vision Broadcast Network, and his consultant Ashif Jiwa with “defrauding investors in a purported startup television network and production company by providing false information about its revenues and future prospects.” The Commission alleges that Mathe and Jiwa raised at least $5.7 million from close to 100 investors across the United States. The US Attorney’s Office for the Eastern Distrit of Pennsylvania announced criminal charges against the defendants in parallel to the SEC’s charge. The company in question, Vision Broadcast, is now dissolved.

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